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Friday, October 30, 2009

More Takes on the Fed's Monetary Superpower Status

As a follow up to my previous post, here are some more articles that point to the Federal Reserve (Fed) as a monetary superpower. Before I get to them I want to be clear why this discussion is important: if the Fed is a monetary superpower then it was more than a passive player during the global liquidity glut of the early-to-mid 2000s--it was an enabler. Moreover, the monetary superpower status means the Fed will continue to shape global liquidity conditions for some time to come. Until the Fed takes this role and the responsibilities that come with it seriously, it is likely to create more distortions in the global economy.

Now on to the articles. First up is Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.2 I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary policy and was more the cause rather than the consequence of the funding coming from Asia.

Along these same lines Sebastian Becker of Deutsche Banks makes the following case:

[I]t might well be the case that excess savings in emerging markets and the resulting re-investment pressure on developed economies’ asset markets contributed to the pronounced fall in US long-term interest rates between 2000 and 2004. Nevertheless, a simple graphical depiction of the US Fed funds rate and selected US long-term market interest rates (as e.g. 15-year and 30-year fixed mortgage rates) rather suggests that the Federal Reserve’s monetary policy stance was the major driver behind low US market interest rates. [See the figure below-DB] Correlation analysis confirms that US mortgage rates and US Treasury yields have both been strongly positively correlated with the official policy rate since the early 1990s. Although global imbalances and the corresponding rise in world FX reserves are likely to have contributed to very favourable liquidity conditions prior to the crisis, the savings-glut hypothesis does not seem to tell the full story. Instead, what really caused global excess liquidity might have been the combination of very accommodative monetary policies in advanced economies between 2002-2005 coupled with fixed or managed floating exchange rate regimes in major emerging market economies such as China or Russia. Consequently, emerging markets implicitly imported at that time the very accommodative MP stance of the advanced economies. (Click on Figure to Enlarge):

The entire Becker piece is worth reading and is a follow-up to another interesting article he did on global liquidity in 2007.

Finally, let's turn to Scott Sumner for how the Fed could use its monetary superpower status in a productive manner going forward:

If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.

The Fed abused its monetary superpower status in the past by creating a global liquidity glut that in turn fueled a global nominal spending spree. Now the Fed has a chance to redeem itself by stabilizing global nominal spending and preventing the emergence of global deflationary forces.

6 comments:

And one reason for the strength of the correlation between short and long rates in the US would be the way that the Fed uses coupon passes covering the range of treasury maturities to collateralise the base money that they add to hold short term interest rates down (the Fed may lend money - ie buy short-term debt - in the first instance, but as the expansion in the base money supply begins to look permanent, the Fed buys treasuries to replace this short-term debt).

In a previous paper by Calvo, Izquierdo and Talvi, Sudden Stops and Phoenix Miracles in EM's (2006), they find that high dollarization in conjunction with high current account deficits and a low supply of tradeables greatly increases the probability of sudden stops. He also argues that global capital turmoil creates a temporal bunching of these sudden stops and names the Russian crisis time period an example of this bunching of sudden stops. I'm wondering if the decrease in global demand along with the accumulation of reserves in emerging markets will lead to any sudden stops going forward seeing as a devaluation in EM's could be a possible policy choice to boost their export competitiveness.

I'd say that the ecb and boj lag behind the fed because inflation lags behind nominal spending as prices are sticky in the short term and the ecb's and boj's response functions put more weight on inflation and less on the output gap.

mb98, you are right that one needs to be careful about confusing correlation with causation. In this case, however, there are good reasons to view the Fed as a monetary hegemon. First, there is a good story to explain the casual links. It starts with the fact that the Fed holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across a large part of the globe. (Ken Rogoff says around 60% of global economy.)This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. That makes its a monetary superpower.

Second, there are also empirical studies that suggest an inordinate role for the Fed in influencing global liquidity conditions. For example, see this article from the ECB or this article from the CES. Also, here is some research showing Fed announcements shape Euro interest rates but not vice versa.

As RebelEconomist notes elsewhere on this blog, the Fed's monetary superpower status is not a given. If at some point (1) dollar block countries quit pegging to the dollar and (2) officials at the BoJ and ECB start conducting monetary policy without worrying about the implications for the competitiveness of their exports then the Fed's time is up.